Reprinted with permission from the Society of FSP ...

Reprinted with permission from the Society of FSP.

Reproduction prohibited without publisher¡¯s written permission.

Investing in Stocks inside

Retirement Accounts and

Bonds in Taxable Accounts

by Greg Geisler, PhD, CPA

ersonal finance writers like Jonathan Clements recommend having ¡°tax-efficient investments in your taxable account, while using

your retirement accounts to hold investments that generate big annual tax bills.¡±1 Properly applying this advice is a challenge. Generally, the advice on where to

hold stocks and bonds assumes the tax law is the only

relevant factor for where a high-income individual¡¯s investments should be held, and a typical suggestion is the

following: Hold taxable bonds in retirement accounts

while holding stock index funds in the taxable account.2

However, Anderson and Murphy point out that tax

rates are one of three factors that matter: ¡°The best [location] depends on factors such as rates of return, tax

rates, and the investment horizon.¡±3 Because of their

tax-favored treatment, any retirement account results in

an investment having a higher after-tax rate of return

than the same investment¡¯s after-tax rate of return if it

is held in a taxable (i.e., personal or nonqualified) account.4 Given this fact, from a tax-efficiency viewpoint,

to maximize wealth all investments should be held inside retirement accounts. However, many individual

investors invest some funds inside retirement accounts

and some funds in taxable accounts each year. The latter

investments are generally made either for liquidity reasons or because the individual invests more for the year

than is allowed inside all of his or her retirement account

opportunities. This article ignores the former reason for

investing in taxable accounts and focuses on the latter.

P

ABSTRACT

It is widely held that investing in bonds inside retirement accounts and stocks inside

taxable accounts is tax efficient. This view

leads to the rule of thumb that ordinary-income-producing investments should be held

inside retirement accounts. This rule does

not stand up to scrutiny. This article shows

that, if the economic environment is one of

low expected inflation, low expected bond

returns, and expected stock returns about

double (or more) bond returns, investing in

stocks with contributions to retirement accounts and buying investment-grade bonds

in taxable accounts are wealth maximizing.

Vol. 71, No. 5 | pp. 77-89

This issue of the Journal went to press in August 2017.

Copyright ? 2017, Society of Financial Service Professionals.

All rights reserved.

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | SEPTEMBER 2017

77

Investing in Stocks inside Retirement Accounts and

Bonds in Taxable Accounts

Greg Geisler

Prior Research

in taxable accounts, given a 12-year investment horizon and the following expected returns and tax rates:

? The expected return on such stocks is approximately double (or more) the expected return on bonds

when the ordinary tax rate (t) = 33 percent and

long-term capital gains tax rate (g) = 15 percent.

? The expected return on such stocks is approximately

80 percent higher (or more) than the expected return

on bonds when t = 28 percent and g = 15 percent.

? The expected return on such stocks is approximately

two-thirds higher (or more) than the expected return

on bonds when t = 25 percent and g = 15 percent.9

Shynkevich does a historical analysis of stock and

bond returns and finds that in the middle part of the

last century, times characterized by low inflation, low

bond returns, and dividend yields exceeding the returns

on 10-year Treasury bonds, tax sheltering (i.e., placing

inside retirement accounts) stocks outperformed tax

sheltering bonds.10 One of the conclusions by Daryanani and Cordaro is that ¡°low-return [investments]

can be placed in either [an IRA or a taxable] account,

since the difference in end-wealth will be small.¡±11

The economic environment early in 2017 is an expectation of low (but increasing) inflation, low bond

returns, and, given the historical annual return on

stocks, stock returns of double or more that of bond returns.12 If the bond returns turn out to be low and the

return on stocks turns out to be near historical averages, then stock inside retirement accounts and bonds

in taxable accounts is the wealth-maximizing strategy.

This is in contrast with the traditional view.

This article focuses on providing breakeven lines

for financial planning practitioners to decide whether

it is tax efficient (i.e., wealth maximizing) to place

stocks or bonds inside retirement accounts while

placing the other in taxable accounts.13 Table 1 shows

the formulas used in this paper. They all assume that

any after-tax earnings are reinvested in the same investment. Comparing the Roth retirement account

(model 5) and the tax-deferred retirement account

(model 4), these two formulas are equal when t0 = tn

and the after-tax amount put into both is the same.

Prior research has come to conflicting conclusions

about whether to hold stocks or bonds inside taxable

accounts versus retirement accounts. Dammon et al.

conclude that there is a ¡°strong preference for holding

taxable bonds in the tax-deferred [401(k) or traditional

IRA] account and equity in the taxable account.¡±5 The

analysis by Horan and Al Zaman concludes that equity

generally should ¡°be located in the taxable account because it is relatively tax efficient.¡±6 In three papers that

Reichenstein either authored alone or coauthored, the

conclusions include the following: ¡°The optimal asset

location is to¡­hold stocks in taxable accounts¡± (from

Reichenstein 2007a); ¡°Except in extreme cases, individuals should locate bonds in retirement accounts and

stocks in taxable accounts¡± (from Reichenstein 2007b);

and ¡°Except in rare cases, investors should hold stocks

in taxable accounts and bonds in retirement accounts¡±

(from Reichenstein and Meyer).7 This conclusion to

hold bonds in retirement accounts and stocks in taxable

accounts will be called the traditional view.

An article put out by mutual fund giant Vanguard

is consistent with this view.8 To summarize the article,

more than 70 percent of the approximately 1.1 million Vanguard investors with both IRAs and taxable

accounts have located their investments tax efficiently. The article states that ¡°if you don¡¯t own bonds¡­

in taxable accounts,¡± ¡°your assets are well-located.¡± In

contrast, 29 percent ¡°have bonds and/or active[ly managed stock mutual] funds in taxable accounts, and index

[stock mutual] funds and/or individual stocks in IRAs.¡±

The article stated that such investors ¡°have opportunities for better asset location [and] may be paying more

in taxes than they need to.¡± The present article calls into

question Vanguard¡¯s claim that it is not tax efficient to

own bonds in taxable accounts while owning a mutual

fund invested in a passive stock index inside an IRA.

The conclusions from other articles are not expressed with such certainty. For instance, the analysis in Anderson and Murphy is broadly consistent

with the tax-efficient asset location being non-dividend-paying stocks in retirement accounts and bonds

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | SEPTEMBER 2017

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Investing in Stocks inside Retirement Accounts and

Bonds in Taxable Accounts

Greg Geisler

For now, it is assumed that this is the case. Later in

the article, the assumption that makes these two retirement accounts equal will be changed.

cent in recent years (i.e., from the beginning of 2012 to

the end of 2014) according to the Yearbook, it is appropriate to reduce the annualized returns on the stocks and

bonds from their historical averages¡ªwhich includes inflation. The comparisons that follow show that 8 percent

is used as the expected return on stocks and 4 percent is

used as the expected return on ¡°taxable¡± bonds.

What Rates of Return

Should Be Used in Comparisons?

Ibbotson lists the returns on large-cap stocks, longterm corporate bonds, and long-term (federal) government bonds.14 The 2015 Yearbook shows that for the

period from January 1, 1926, through December 31,

2014, the geometric means of the annualized returns

were 10.1 percent, 6.1 percent, and 5.7 percent, respectively.15 Ibbotson also lists inflation, and for the same

period the geometric mean of the annualized rate is 2.9

percent. Given that inflation has averaged only 1.5 per-

Assumptions and Comparisons

It is assumed that it is the start of the year and an

employee who has reached age 50 will invest $50,000

of the employee¡¯s pretax salary. For simplicity, $25,000

is assumed to be the maximum pretax amount that

can be contributed to the employee¡¯s 401(k).16 The remaining after-tax salary must be invested outside the

TABLE 1

Relevant Formulas29

Is Initial

Rate of

Frequency

Investment

Investment Model (Example)

Taxation

of Taxation

Deductible?

Future Value of Investment

After Taxes (ATFV)

Model 1: Taxed annually at ordinary rate

(e.g., certificate of deposit, taxable bond)

Ordinary

Annual

No

= AT$ [1 + R (1 ¨C t)] n

Model 2: Taxed annually and rate is

favorable because of qualified dividends

and/or capital gain distributions (e.g.,

actively managed mutual fund of stocks)

Favorable

Annual

No

= AT$ [1 + R (1 ¨C g)] n

Model 3: Tax deferred until sale and rate

is favorable since long-term capital gain

(e.g., stock that pays no dividends)

Favorable

Deferred

No

= AT$ [(1 + R)n (1 ¨C gn ) + gn]

Model 4: Tax savings at contribution and

Ordinary

Deferred

Yes

tax deferred until payout [e.g., 401(k),

403(b), deductible IRA]

= AT$ (1 + R)n (1 ¨C tn )

(1 ¨C t0 )

Model 5: Tax free [e.g., Roth IRA,

Roth 401(k)]

= AT$ [1 + R] n

where:

ATFV =

AT$ =

R =

n =

t =

t0 =

tn =

g =

gn =

None

Never

No

After-tax future value

After-tax dollars invested

Before-tax rate of return

Investment horizon (in years) (i.e., holding period)

Marginal ordinary tax rate annually

Marginal ordinary tax rate today (year 0)

Marginal ordinary tax rate at end of investment horizon (year n).

Marginal favorable tax rate annually

Marginal favorable tax rate at end of investment horizon (year n).

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | SEPTEMBER 2017

79

Investing in Stocks inside Retirement Accounts and

Bonds in Taxable Accounts

Greg Geisler

401(k). For simplicity, it is also assumed that the investments will be made on the first day of the year.

Given the tax law, which location to hold each asset in

is important, but it is not the only important criterion

to determine the proper place to hold an investment.

Another important piece of information is the expected return on the investment. For example, the employee could invest $25,000 of pretax salary in a qualified

tax-deferred account (TDA) like a 401(k) and $25,000

of pretax salary outside a qualified retirement account

(i.e., outside in a taxable account) this year. In this example, the employee chooses to invest $25,000 in taxable bonds with a return of 4.0 percent inside a TDA

and $18,750 (after-tax salary assuming a 25 percent

tax rate) in a mutual fund of stocks (i.e., a hybrid of

models 2 and 3) with a return of 8 percent, of which

one-quarter (i.e., 2 percent) is annual dividends and

three-quarters (i.e., 6 percent) is annual appreciation.17

The approach focusing only on the tax law would say

to hold the lower-yielding taxable bonds in the retirement account because they yield ordinary income that

gets taxed at the higher ordinary rates and to hold the

stocks outside in a taxable account because they are

taxed favorably. The after-tax future values (ATFVs) in

the scenarios (i.e., comparisons) that follow show this

is the wrong conclusion. In scenario 1 in Figure 1, the

individual is assumed to have a marginal ordinary tax

rate (t) that is always 25 percent on interest and a marginal tax rate on dividends and long-term capital gains

(g) that is always 15 percent.18 The investment horizon

is assumed to be 20 years. Later in the article, this assumption about the length of the investment horizon

FIGURE 1

Scenario 1

n = 20; RS = 8%; R B = 4%; t = 25%; g = 15%

Stocks In-Bonds Out:

Stocks in TDA (model 4)

$25,000(1.08)20(1 ? .25)

Bonds in taxable account (model 1)

$18,750[1 +.04(1 ? .25)]20

ATFV

Bonds In-Stocks Out:30

Bonds in TDA (model 4)

$25,000(1.04)20(1 ? .25)

Stocks in taxable account

$18,750(1.08 ? .003)20 ? .15{$18,750(1.08 ? .003)20 ?

(hybrid: models 2 and 3)31

18,750[(.75 + (1.08 ? .003)20 .25(1 ? 0.15)) / 1 ? (.25 ¡Á .15)]}

ATFV

$ 87,393

33,865

$121,258

$ 41,084

75,193

$116,277

FIGURE 2

Scenario 2

n = 20; RS = 8%; R B = 4%; t = 25%; g = 15%; tn = 15%; gn = 0%

Stocks In-Bonds Out:

Stocks in TDA (model 4)

$25,000(1.08)20(1 ? .15)

Bonds in taxable account (model 1)

$18,750 (1 +.04(1 ? .25))20

ATFV

$ 99,045

33,865

$132,910

Bonds In-Stocks Out:

Bonds in TDA (model 4)

$25,000(1.04)20(1 ? .15)

Stocks in taxable account (hybrid: models 2 and 3)32

$18,750(1.08 ? .003)20

ATFV

$ 46,561

82,664

$129,225

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | SEPTEMBER 2017

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Investing in Stocks inside Retirement Accounts and

Bonds in Taxable Accounts

Greg Geisler

will be changed. Scenario 1 in Figure 1 shows the individual will be wealthier (i.e., have a higher ATFV)

by 4.3 percent [($121,258 ? $116,277) / $116,277] if

the stock is held inside the TDA and the bond is held

outside in a taxable account.19 The intuition behind

the conclusion from this scenario is there is a limited amount of money that can be put into retirement

accounts, so an investor should take the greatest tax

advantage possible with such accounts. The mutual

fund of stocks whose return consists partly of qualified

dividends and partly of long-term capital gain when it

is sold in 20 years is subject to a small amount of tax

annually and a significant amount when sold, so having this high-return (R = 8 percent) investment inside

the retirement account avoids a lot of tax.20

increases the after-tax value of the retirement account a

lot. This is tempered slightly by the fact that in Bonds

In-Stocks Out, the bonds held in the retirement account are taxed at only 15 percent instead of 25 percent.

Further, it is tempered significantly by the fact that the

stocks¡¯ appreciation when held in the taxable account is

taxed at 0 percent instead of 15 percent.

Summary of Scenarios

In both scenarios thus far, n = 20 years, t0 = 25

percent, and g0 = 15 percent. The other variables and

results of both scenarios are listed in Table 2.

Assume that instead of being 8 percent, RS is

higher, and/or that instead of being 4 percent, R B is

lower. For scenarios 1 and 2, Stocks In-Bonds Out

instead of Bonds In-Stocks Out will increase wealth

by a larger percentage than as depicted in Table 2.

Further Analysis:

Tax Rate Changing after n Years

Sensitivity Analysis¡ªChange

n = 20 Years to 10 Years or 30 Years

The next scenario uses the same facts but relaxes the assumption that t = tn . The assumption that

t = 25 percent remains but now, in scenario 2, tn = 15

percent. This is consistent with the individual being

retired from work and the resulting drop in income

reducing that individual¡¯s tax bracket. Since tn is below 25 percent, consistent with current tax law it is

also assumed that gn = 0 percent, instead of 15 percent.21 Returning to the facts of scenario 1, but with

the new percentages for tn and gn , the results for scenario 2 are shown in Figure 2.

In scenario 2, the ATFVs for Stocks In-Bonds Out

versus Bonds In-Stocks Out are not spread as widely

apart as in scenario 1. Specifically, the individual will

be wealthier by 2.9 percent [($132,910 ? $129,225) /

$129,225] if the stocks are held inside the TDA and the

bonds are held outside in a taxable account. Compared

with scenario 1, the bonds held in the taxable account

have the same ATFV, but all of the other ATFVs increase

due to the lower tax rate at year n. Stocks In-Bonds Out

is not as strong of a winner in scenario 2 compared with

scenario 1, despite the fact that the biggest increase in

ATFV is the stock held in the retirement account, where

the decrease in the tax rate from 25 percent to 15 percent

In this example, it continues to be assumed that

RS = 8 percent and RB = 4 percent. As stated earlier,

Anderson and Murphy point out that ¡°the best [location of stocks and bonds] depends on¡­rate of return, tax rates [throughout the life of the investment],

and the investment horizon.¡± The analysis thus far

has varied the first two variables but not the last variable, which is investment horizon. It is possible that

TABLE 2

Other Variables, Scenario Results

Scenario 1

Scenario 2

tn

25%

15%

gn

15%

0%

[1] ATFV:

Stocks In-Bonds Out

$121,258

$132,910

[2] ATFV:

Bonds In-Stocks Out

$116,277

$129,225

[1] ¨C [2] = [3] Difference

$4,981

$3,685

[3] / [2] Percentage increase

4.3%

2.9%

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | SEPTEMBER 2017

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